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CHAPTER 2: Financial Statement Audits andAuditors’ Responsibilities

QUESTIONSTrue/FalseREQUIRED: For each of the following items, indicate whether it is (T) True or (F) False. For those marked “False,” identify the error(s) and indicate the change or changes that are needed to make the statement true. 1. The primary objective of auditing is to add credibility to the financial

statements prepared by management. 2. Auditing is not possible in the absence of verifiable data. 3. Compliance with “Statements on Auditing Standards” is mandatory for all

auditors. 4. The training called for by the first general standard comes solely from

practical experience.

5. The second general standard likens the auditor’s role in an audit to the role of an attorney in a legal case.

6. No provisions exist for meeting the first reporting standard when a company uses a comprehensive basis of accounting other than GAAP.

7. The third general standard requires the auditor to act in good faith and not to be negligent in an audit.

8. The fourth reporting standard requires the auditor to express an opinion either on the financial statements taken as a whole or on selected major components of the financial statements.

9. In most cases, when disclosure in the financial statements is considered inadequate, the auditor’s report must include the necessary information.

10. The concepts of materiality and risk affect the application of all ten auditing standards.

11. The auditing standards are more applicable to audits of public companies than to audits of nonpublic companies.

12. The main purpose of the audit committee is to monitor the competence of the external auditors during the course of the engagement.

13. Auditing procedures are the methods used and the acts performed by the auditor during an audit.

14. It is permissible under GAAS for the internal auditor to provide direct assistance to the independent auditor.

15. The internal auditor is responsible for the preparation of the financial statements.

2-116. The auditor’s report should make explicit reference to the management

responsibility report.

17. In the opinion paragraph, reference is made to the listed financial statements, but their names are not repeated.

18. A disclaimer of opinion may be substituted for an adverse opinion.19. The concept of reasonable assurance does not guarantee the accuracy of the

financial statements.20. In the case of a very material departure from GAAP, the best course of action

is usually to disclaim an opinion.21. Auditors are responsible for planning and performing an audit to obtain

reasonable assurance that the financial statements are free of material misstatement.

22. SAS 82, Consideration of Fraud in a Financial Statement Audit, states that the auditor’s interest specifically relates to fraudulent acts that cause material misstatements in financial statements.

23. When the auditor concludes that the financial statements are materially misstated and are not prepared in accordance with GAAP, the auditor should revise the financial statements.

24. SAS 82 essentially makes the audit report a guarantee.25. SAS 54, Illegal Acts by Clients, indicates that the auditor’s responsibility for

misstatements resulting from illegal acts having a direct and material effect on the determination of financial statement amounts is the same as for errors or fraud.

26. The auditor’s responsibility for other illegal acts is restricted to information that comes to his or her attention.

27. An audit made in accordance with GAAS provides strong assurance that all illegal acts will be detected.

28. The payment of a bribe is an example of an error.29. Fair presentation of financial statements in accordance with GAAP is not a

guarantee of the continuation of an entity as a going concern.30. If management concludes adequate disclosures in the financial statements

concerning the entity’s ability to continue as a going concern, the auditor would issue a qualified opinion on the financial statements with an additional paragraph explaining the going concern uncertainty.

31. Auditors are challenged to be able to perform real-time audits so that management can issue real-time financial statements.

32. The accounting profession is developing a narrower array of assurance services.

2-2Answers to True/False 1. T. 2. T. 3. F: All auditors should be members of the AICPA. 4. F: Such training also comes from formal education and continuing

professional education.

5. F: An attorney should be an arbitrator or a judge. 6. F: Special provisions exist for meeting the standard when a company uses a

comprehensive basis of accounting other than GAAP. 7. T. 8. F: On selected major components of the financial statements should

be state that an opinion cannot be expressed.

9. T.10. T.11. F: More should be equally; than to audits of should be and.12. F: Monitor the competence should be strengthen the independence.13. T.14. T.15. F: The internal auditor should be Management.16. F: Explicit should be no.17. T.18. F: May should be cannot.19. T.20. F: Disclaim an should be issue an adverse.21. T.22. T.23. F: revise the financial statements should be insist that the financial

statements be revised by management.

24. F: Essentially makes should be does not make.25. T.26. T.27. F: Strong should be no.28. F: Error should be illegal act.29. T.30. F: A qualified should be an unqualified.31. T.32. F: Narrower should be wider.

2-3Multiple ChoiceREQUIRED: Indicate the best answer choice for each of the following. 1. Which one of the following is not among the conditions that give rise to a

demand by external users for independent audits of financial statements?a. remoteness of usersb. complexity of subject matterc. the securities acts, administered by the SECd. potential conflict of interest between users and preparers of the

statementse. consequence for making decisions

2. There are four conditions that give rise to the need for independent audits of financial statements. One of these conditions is complexity. In this context, complexity relates to all of the following except complexity:a. of the accounting process.b. in evaluating the quality of financial statements.c. of financial statement preparation.d. of the subject matter, or GAAP.e. of the decision process.

3. Financial statement audits may have a direct effect on a number of items. Such audits are least likely to have a direct effect on:a. the market price of a company’s stock.b. employee honesty and efficiency.c. cost of borrowed capital.d. management’s role in the preparation of the financial statements.e. employee attitude toward fraud.

4. There are four conditions that give rise to the need for independent audits of financial statements. One of these conditions is consequence. In this context, consequence means that the:a. users of the statements may not fully understand the consequences of

their actions.b. auditor must anticipate all possible consequences of the report issued.c. impact of using different accounting methods may not be fully

understood by the users of the statements.d. financial statements are used for important decisions.e. financial statements were prepared in accordance with GAAS.

5. Auditing is based on the assumption that financial data are verifiable. Data are verifiable when two or more qualified individuals,a. working together, can prove, beyond doubt, the accuracy of the data.b. working independently, each reach essentially similar conclusions.c. working independently, can prove, beyond reasonable doubt, the truthfulness

of the data.d. working together, can agree upon the accuracy of the data.

e. working together, each reach essentially similar conclusions.

2-4 6. The need for independent audits of financial statements can be attributed to

all of the following conditions except:a. remoteness.b. complexity.c. consequence.d. validity.e. conflict of interest.

7. Which of the following best describes the relationship that should exist between the external auditor and the management of the client company?a. adversarial relationshipb. mutual trust and respectc. advocacy of management’s positiond. mutual caution and suspicione. skeptical vigilance

8. The primary purpose of the Audit Committee is to:a. monitor the professional competence of the auditor.b. relieve management of the need to interact, on a day-to-day basis, with

the external auditor.c. strengthen the independence of the external auditors.d. act as liaison between the external auditors and the internal auditors.e. discuss the scope of the audit with the auditor.

9. Within the generally accepted auditing standards, the general standards relate primarily to:a. qualifications of the auditor and the quality of the auditor’s work.b. qualifications of the auditor.c. the relationship between GAAS and generally accepted accounting

principles.d. the fairness of the financial statements.e. the general distribution of audit reports.

10. The essence of the due care standard is that the auditor should not be guilty of:a. bias.b. objectivity.c. errors in judgment.d. fraud.e. negligence.

11. Which of the following is an incorrect statement concerning one of the field work standards?a. Audit planning includes the development of audit strategies.b. Audit planning is aimed primarily at effectiveness, with little effect on

efficiency.

c. Understanding of the internal control structure is necessary in order to plan the audit.

d. Proper supervision is essential because major portions of the audit are often executed by staff assistants with limited experience.

e. The auditor must have a reasonable basis, in the form of gathered evidence, for expressing an opinion.

2-512. Every independent audit engagement involves both auditing standards and

auditing procedures. The relationship between the two may be illustrated by how they apply from engagement to engagement. The best representation of this application is that, from one audit engagement to the next,

Auditing AuditingStandards Procedures

a. apply uniformly apply uniformly.

b. may vary apply uniformly.

c. apply uniformly may vary.d. may vary may vary.e. apply uniformly are optional.

13. Which one of the following was not listed as an inherent limitation of a financial statement audit?a. accounting estimatesb. reasonable length of timec. alternative accounting principlesd. reasonable coste. level of complexity

14. According to SAS 54, the auditor’s responsibility for illegal acts is:a. greater than for errors or fraud.b. the same as it is for errors or fraud.c. less than it is for errors or fraud.d. different for direct-effect illegal acts and other types of illegal acts.e. restricted to information that comes to his attention.

15. If the client refuses to accept an audit report that is qualified due to the known existence of an illegal act, the auditor should:a. withdraw from the engagement and indicate the reasons to the audit

committee in writing.b. issue an adverse opinion if management agrees to fully disclose the

matter.c. withdraw from the engagement and indicate the reasons to the SEC or

other regulatory body in writing.d. issue a disclaimer of opinion instead.e. issue an unqualified opinion if management agrees to fully disclose the

matter.16. Required auditor communication to the Audit Committee concerning illegal

acts

detected includes:a. all material items.b. all that are not adequately addressed by management.c. only those that have an effect on the audit report.d. only those that constitute management fraud.e. any such acts.

2-617. SAS 59 establishes auditor responsibility for evaluating whether there is any

doubt about the entity’s ability to continue as a going concern for a reasonable period of time. This reasonable period of time is defined as:a. at least one year past the date of the statements under audit.b. at least one year past the date of the audit report.c. not more than two years past the date of the audit report.d. not more than one year past the date of the statements under audit.e. not more than one year past the date of the audit report.

18. When the auditor concludes that there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, and this fact is adequately disclosed in the notes to the financial statements, the auditor’s report should express:a. a qualified opinion due to the uncertainty.b. an unqualified opinion, with a fourth (explanatory) paragraph.c. the standard unqualified opinion.d. a disclaimer of opinion.e. an adverse opinion.

19. Which of the following representations does an auditor make explicitly and which implicitly when issuing a standard unqualified opinion?

Conformity Adequacy of Consistency of

with GAAP disclosure accountinga. Explicitly Explicitly Implicitlyb. Implicitly Implicitly Explicitlyc. Explicitly Implicitly Implicitlyd. Implicitly Explicitly Explicitlye. Explicitly Implicitly Explicitly

20. Which of the following would not be found in the introductory paragraph of the standard audit report?a. a reference to generally accepted auditing standards.b. a list of specific financial statements audited.c. a statement that the financial statements are the responsibility of

management.d. a statement that the auditor’s responsibility is to express an opinion,

based on the audit.e. a reference to the entity audited.

21. The introductory paragraph in the standard audit report identifies all of the following except:a. the existence of the management responsibility letter.b. the entity audited.c. the dates of the statements.d. the auditor’s responsibility for the opinion.e. management’s responsibility for the statements.

2-722. The scope paragraph in the standard audit report uses all of the following

terms except:a. generally accepted auditing standards.b. conclusive basis.c. materiality.d. significant estimates.e. examining evidence.

23. In the opinion paragraph of the standard audit report, the phrase “in our opinion,” really means:a. “we certify...”b. “we guarantee...”c. “we are certain...”d. “we are reasonably satisfied...”e. “we promise...”

24. The use of the phrase “present fairly, in all material respects” in the opinion paragraph is most closely associated with which of the following concepts from the scope paragraph?a. test basisb. substantial guaranteec. positive conclusiond. basis for an opinione. significant estimates

25. In the standard audit report, the auditor’s opinion on fairness pertains:a. only to the complete set of financial statements.b. to individual accounts.c. to each financial statement taken as a whole.d. to major components of each financial statement.e. only to material aspects of each financial statement.

26. When a user sees that a standard unqualified opinion has been expressed by an external auditor, he or she may correctly infer that:a. no material errors were found during the engagement.b. no embezzlements remain undetected.

c. any system defects encountered during the engagement have been corrected to the auditor’s satisfaction.

d. any differences between management and the auditor on accounting matters have been resolved to the auditor’s satisfaction.

e. any detected management fraud is immaterial.27. A disclaimer of opinion really states that:

a. no opinion can be formed.b. no audit was attempted.c. except for some minor errors the statements are fair.d. the financial statements are wrong.e. the audit was aborted.

2-828. If the financial statements contain a departure from GAAP, the auditor should

express:a. an adverse opinion.b. a qualified opinion.c. a disclaimer of opinion.d. either a disclaimer of opinion or a qualified opinion.e. either a qualified opinion or an adverse opinion.

29. If an extremely material scope limitation exists, the auditor should express:a. an adverse opinion.b. a qualified opinion.c. a disclaimer of opinion.d. either a disclaimer of opinion or a qualified opinion.e. either a qualified opinion or an adverse opinion.

30. SAS 54 lists a number of items that may provide evidence concerning possible illegal acts. They include which one of the following?a. authorized transactionsb. investigations by governmental agenciesc. failure to file statements with the SECd. failure to amend tax returnse. related party transactions

31. Which one of the following terms relates to the embezzling of receipts?a. manipulationb. misrepresentationc. misappropriationd. misapplicatione. misleading

32. A significant aspect of conducting an audit with due professional care is the auditor’s attitude of professional:a. pessimismb. skepticismc. optimism

d. courtesye. decorum

33. An auditor may be required to disclose fraud outside the client entity in each one of the following situations except:a. in response to a court subpoena.b. to the SEC when the auditor has withdrawn from the engagement.c. to a successor auditor who makes inquiries in accordance with

professional standards.d. to the GAO when the auditor has reported illegal acts to the audit

committee.e. to a funding agency in accordance with audit requirements for entities

that receive governmental financial assistance.

2-934. Which one of the following is not an example of fraud?

a. the falsification of accounting recordsb. the intentional omission from the financial statements of transactionsc. the intentional misapplication of accounting principles relating to

amountsd. the stealing of assetse. the payment of a bribe

35. Which one of the following is an indicator that may indicate an increased risk of illegal acts?a. failures to file income tax returnsb. authorized transactionsc. inquiries by governmental agenciesd. a substantial number of reclassificationse. the presence of obsolete items in inventory

36. Which of the following is true concerning the effect of information technologies?a. The use of computerized accounting and information systems have

increased the time needed to measure, record, classify, and summarize accounting information.

b. Timely and accurate information for decision making is unimportant for financial statement users.

c. Financial statement users have no doubt that the appropriate target of the audit will always be the financial statements.

d. Auditors need to adapt to perform real-time audits.e. Audit firms are exploring how they can improve the reliability of the audit

product.

Answers to Multiple Choice1. c 13. e 25. c2. e 14. b 26. d3. a 15. a 27. a4. d 16. e 28. e

5. b 17. d 29. c6. d 18. b 30. b7. b 19. c 31. c8. c 20. a 32. b9. a 21. a 33. d

10. e 22. b 34. e11. b 23. d 35. a12. c 24. e 36. d

2-10Matching 2-1 (5 minutes)The ten generally accepted auditing standards are listed below in paraphrased form. Indicate the category to which each statement belongs by placing the following letters in the spaces provided:

G: General,F: Field work, orR: Reporting,

1. An understanding of the internal control structure is to be obtained.2. The auditor should be unbiased during the examination.3. The financial statements should be in conformity with GAAP.4. The financial statements contain adequate disclosures.5. The auditor should have adequate technical training and proficiency as

anauditor.

6. Sufficient competent evidential matter is to be obtained.7. Due professional care is to be exercised by the auditor.8. The work should be adequately planned and assistants should be

properlysupervised.

9. The report shall contain an expression of opinion.10. Circumstances in which GAAP have not been consistently observed

should beidentified.

Answers — Matching 2-11. F 3. R 5. G 7. G 9. R2. G 4. R 6. F 8. F 10. R

2-11Matching 2-2 (10 minutes)Words and phrases from the auditor’s standard report are given below. Indicate where the item should appear in the report by placing the following letters in the spaces provided:

I: Introductory,S: Scope, orO: Opinion.

Item1. We have audited2. statements of income, retained earnings, and cash flows3. in accordance with GAAS4. in conformity with GAAP5. Our responsibility is to express an opinion6. responsibility of the Company’s management7. statements are free of material misstatement8. results of its operations and its cash flows9. in all material respects

10. examining, on a test basis,11. assessing the accounting principles used12. evaluating the overall financial statement presentation

13. financial position of X Company14. supporting the amounts and disclosures in the financial statements15. a reasonable basis for our opinion

Answers — Matching 2-21. I 4. O 7. S 10. S 13. O2. I 5. I 8. O 11. S 14. S3. S 6. I 9. O 12. S 15. S

Short Answer 2-1 (10 minutes)A financial statement audit made in accordance with GAAS is subject to a number of inherent limitations. Briefly discuss (a) the two important economic limits and (b) the two important limitations associated with the established accounting framework.

2-12Answers — Short Answer 2-1(a) (1) Reasonable cost. A limitation on the cost of an audit results in

selective testing, or sampling, of the accounting records and supporting data. Also, the auditor may decide to test internal controls and obtain assurance from a well-functioning system of internal controls.

(2) Reasonable length of time. The auditor’s report on public companies is normally issued three to fine weeks after the balance sheet date, and this time constraint may affect the amount of evidence that can be obtained in regard to events and transactions after the balance sheet date that may have an effect on the financial statements. In addition, there is a relatively short time period available for the resolution of uncertainties existing at the financial statement date.

(b) (1) Alternative accounting principles. Alternative accounting principles are permitted under GAAP, and financial statement users must be knowledgeable about an entity’s accounting choices and their effect on the financial statements.

(2) Accounting estimates. Estimates are an inherent part of the accounting process, and no one can foresee the outcome of uncertainties. An audit cannot add exactness and certainty to financial statements when these factors do not exist.

Short Answer 2-2 (10 minutes)During a financial statement audit, the auditor maintains professional relationships with four important groups. Briefly explain each of these relationships.

Answers — Short Answer 2-2(a) Management — From an auditing standpoint, management refers to the

company officers, controller, and key supervisory personnel. During the course of an audit, there is extensive interaction between the auditor and management.

The auditor often requires confidential data about the entity while obtaining evidence, and it is therefore imperative to have a relationship based on mutual respect and trust. The approach the auditor should take towards management’s assertions may be characterized as one of professional skepticism.

(b) Board of directors and audit committee — A corporation’s board of directors is responsible for ensuring that the firm is operated in the best interest of the stockholders. When the board is mostly made up of company officers, the auditor’s relationship with the board and management is the same.When the board has some outside members, the board (or a designated audit committee composed exclusively or primarily of outside board members) can serve as an intermediary between the auditor and management.

2-13During the last ten years, there has been a profound increase in the use of audit committees as means of strengthening auditors’ independence. Audit committee functions that directly affect the independent auditor are:(1) Nominating the public accounting firm to conduct the annual audit.(2) Discussing the scope of the audit with the auditor.(3) Inviting direct auditor communication on major problems encountered

during the course of the audit.(4) Reviewing the financial statements and the auditor’s report with the

auditor on completion of the engagement.Since the board of directors is interested in the auditor’s business expertise and knowledge about the company’s business risk and competitiveness factors, the audit committee plays an important role in strengthening the auditor’s ability to apply the appropriate professional skepticism in an engagement.

(c) Internal auditors — An independent auditor normally has a close working relationship with the client’s internal auditors, and has a direct interest in the work of internal auditors that pertains to the client’s internal control structure. It is also permissable for internal auditors to provide direct assistance to the external auditor in performing a financial statement audit.The internal auditor’s work cannot be used as a substitute for the external auditor’s work, but it can be an important complement. In determining the effect of such work on the audit, the independent auditor should:(1) consider the competence and objectivity of the internal auditor and(2) evaluate the quality of the internal auditor’s work.

(d) Stockholders — Stockholders rely on audited financial statements for assurance that management has properly discharged its stewardship responsibility, and the auditor therefore has a serious responsibility to stockholders as the primary users of the audit report. During the course of an engagement, auditors are not likely to have direct personal contact with stockholders who are not officers, key employees, or directors of the client, but may attend the annual stockholders’ meeting and answer stockholders’ questions.

2-14Analysis 2-1 (15 minutes)The following audit report was issued by the CPA firm of Wong and Lee on a basic set of financial statements:

(0) We have examined the accompanying balance sheet of X Company as of December

31, 19XX, and the related statements of (1) income and retained earnings for the year then ended. These financial statements are the responsibility of the Company’s (2) board of directors. Our responsibility is to express an opinion on these financial statements based on our (3) examination.

We conducted our audit in accordance with (4) professional auditing standards. Those

standards require that we (5) plan and perform the audit to obtain reasonable assurance about whether the financial statements (6) are fairly stated. An audit includes examining, (7) on a detailed basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes (8) judging the accounting practices used and significant (9) decisions made by management, as well as evaluating the (10) completeness of the financial statement presentation. We believe that our audit provides (11) reliable evidence for our opinion.

(12) We believe the financial statements referred to above (13) present fairly, in all

respects, the financial position of X Company as of December 31, 19XX, and (14) the results of its operations and its cash flows for the year then ended (15) in conformity with promulgated accounting principles.REQUIRED: If the wording of each numbered item is correct, enter OK. If the wording is incorrect, give the correct wording.Answer (0) is given as an example.

(0) We have audited.

Answers — Analysis 2-1(1) income, retained earnings, and cash flows(2) management(3) audit(4) generally accepted auditing standards(5) OK(6) are free of material misstatement(7) on a test basis(8) assessing the accounting principles used(9) estimates made by management(10

)overall financial statement presentation

(11)

a reasonable basis for our opinion

(12)

In our opinion, the financial . . .

(13)

present fairly, in all material respects,

(14)

OK

(15)

in conformity with generally accepted accounting principles.

2-15Analysis 2-2 (8 minutes)Identify the specific generally accepted auditing standard for each one of the following descriptions. 1. The report shall either contain an expression of opinion regarding the financial

statements, taken as a whole, or an assertion to the effect that an opinion cannot be expressed.

2. In all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor or auditors.

3. Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit.

4. Due professional care is to be exercised in the performance of the audit and the preparation of the report.

5. The work is to be adequately planned, and assistants, if any, are to be properly supervised.

6. The report shall identify those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.

7. The audit is to be performed by a person or persons having adequate technical training and proficiency as an auditor.

8. Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report.

9. A sufficient understanding of the internal control structure is to be obtained to plan the audit and to determine the nature, timing, and extent of tests to be performed.

10.

The report shall state whether the financial statements are presented in accordance with generally accepted accounting principles.

Answers — Analysis 2-2 1. Fourth Standard of Reporting 2. Second General Standard 3. Third Standard of Field Work 4. Third General Standard 5. First Standard of Field Work 6. Second Standard of Reporting 7. First General Standard 8. Third Standard of Reporting 9. Second Standard of Field Work 10

.First Standard of Reporting

2-16Analysis 2-3 (10 minutes)Data are verifiable when two or more qualified people, working independently, reach similar conclusions from an examination of the data. Verifiability is mainly concerned with the availability of evidence attesting to the validity of the information being considered.What are the challenging aspects involved in verifying a client’s allowance for doubtful accounts?

Answers — Analysis 2-3Whenever an account balance is determined by estimates based on judgmental considerations relating to the future, it is not easily verifiable. In attempting to verify the allowance for doubtful accounts, the following questions must be

addressed: 1. If trade accounts receivable are aged, are the percentages used in the aging

schedule reasonable based on the client’s prior experience with its customers?

2. Is the overall allowance adequate? 3. Based on the feedback provided by accounts receivable confirmations, does

the balance of the allowance for doubtful accounts appropriately relate to the accounts receivable balance?

4. Is the aged trial balance working paper prepared by the auditor the best way to verify the allowance for doubtful accounts?

Note: The student may find it useful to read ahead in chapter 14.

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